Microsoft's Billion-Dollar Question

It's kind of funny when you can write about a company's "billion-dollar question" and have it seem trivial, but such is the case for Microsoft(Nasdaq: MSFT) and its larger high-tech peers. Still, news that Microsoft plans to spend $1 billion on the launch of its new Windows Phone 7 deserves a closer look. Is it too late for Microsoft to get back in the game, even with a massive marketing push?

Buying friendsA lengthy TechCrunch article quoting a Deutsche Bank analyst who spoke with company executives says Microsoft plans to spend about $500 million on marketing and give $500 million to developers and phone makers to subsidize app and handset development. That's just costs for the launch, too; over the course of the year Microsoft and its partners plan to spend "billions." For context, the company spent $13.2 billion on sales and marketing last fiscal year. Of that $13.2 billion, only $1.6 was direct advertising expenses.

The surge of money is needed to give Windows Phone 7 a fighting chance and keep handset makers rapidly coalescing around Google's (Nasdaq: GOOG) Android committed to the platform. After announcing an impressive slate of launch partners, Microsoft has lost support throughout the year. An especially troubling loss was Hewlett-Packard(NYSE: HPQ), which shifted away from Windows Phone 7 and Windows on its tablets after buying Palm.

Lies, damn lies, and statisticsOf course, Microsoft will say it's still early in the game and the company can come back with a strong Windows Phone 7 launch. According to Greg Sullivan, a product manager quoted by TechCrunch:

We have a long-term view and Microsoft has been in this position before in other businesses where we've had to take a long-term view. … The mobile phone market is growing by leaps and bounds, but it's still in the early stages.

Rule No. 1 of the mobile world: Don't believe anyone who says it's still "early." North American and European smartphone penetration rates are over 30%. While that leaves plenty of growth, a set number of users don't want to pay for data plans, so the penetration rate of "available" smartphone users is actually higher.

Second, smartphone users download software (apps) to support their phones, which presents a switching cost. Once someone has loaded their smartphone with tools and games, do they really want to start over on a new operating system? Plus, they get used to the user interface and functionality of their phones. Stealing smartphone buyers from other platforms is difficult; 89% of Apple's (Nasdaq: AAPL) iPhone users and 71% of Android users plan to stick with their current operating system on their next upgrade. I know it's Greg Sullivan's job to wax optimistic, so I don't blame him -- but don't buy the optimism.

Bottom lineI hate to sound dismissive of Windows Phone 7 before it even hits stores, but the deck is stacked against it. Regardless of Windows Phone 7's features, it's just too late in the game. While Microsoft's massive scale gives it the advantage of being able to seed development and handset maker support with its large cash pile, the fact that several partners are pulling away (despite the massive incentives) is troubling.

The smartphone market seems to have hit a tipping point where support for a couple platforms (Android and the iPhone) is snowballing. The two platforms are seeing exponential developer support while Research In Motion(Nasdaq: RIMM) fails over and over again to come up with a competitive high-end phone and Nokia(NYSE: NOK) stays lost in the woods.

However, there are some bright spots for Microsoft. I like what the company is doing with its Xbox Live integration. One of the key reasons Apple has been so successful is how well its software scales (its iOS runs on iPods, the iPhone, and the iPad), and the common theme of iTunes linking up digital media. In the process of creating Windows Phone 7, Microsoft connected Xbox Live -- which has powerful media as well as social elements -- with its operating system. This kind of clean, seamless integration between several consumer devices is an improvement for Microsoft, a company notorious for business units that operate in silos.

It's not that Apple has better innovation talent or outspends Microsoft (Microsoft's R&D budget is over five times as large), it's that Apple has always had a tight focus and a unified experience that appeals to consumers.

Microsoft is trading at a P/E of about 9, net of cash. That suggests that the market isn't expecting much success from Microsoft outside Windows, Office, and its Server and Tools businesses. All the reports of Microsoft's fumbling of the mobile market serve to obscure its innovation in other areas, like cloud computing.

When you're more than three years late to the smartphone game, you take whatever good news you can get. The vital signs on Microsoft's mobile efforts look grim, but that doesn't mean the company's not a good buy at today's prices.

Author

Eric started at The Motley Fool in 2008 working in the Tech & Telecom sector. Today, he's the General Manager of Fool.com. You can follow him on Twitter to stay up to date with his tech industry analysis. Follow @bleekertech